On Jan. 1, 2011, the transition to international financial reporting standards from Canadian generally accepted accounting principles will be complete. And trends in executive compensation make it important that investors and clients are aware of this transition.

While the transition is expected to be as smooth in Canada as it has been in countries that have already adopted IFRS, it is important for investors and directors to keep in mind that publicly traded companies will, after that date, be calculating their bottom line a little differently.

As well, in an effort to reward a broader spectrum of success than an uptick in stock prices, as options do, compensation committees have moved away from traditional executive compensation instruments. They are implementing new metrics — such as measuring the performance of an individual executive and his or her region or division against the overall financial performance of the company — in an effort to tie executive performance to shareholder interests.

As a result, accounting practices are playing an increasingly important role in the construction of compensation models and the calculations of bonuses.

When the decision to switch to IFRS from Canadian GAAP was being made, much was said about the difference between the two systems: Canadian GAAP is based on a set of prescriptive rules, whereas IFRS is principles-based.

Ultimately, however, both systems set out to accomplish the same thing: paint a company’s financial portrait. But based on the strength of IFRS’s focus on comparability, IFRS has emerged as an accounting lingua franca. The European Union adopted IFRS in 2005; Australia and New Zealand followed in 2006 and 2007, respectively.

“There were not any major shocks,” says Ron Salole, vice president of standards with the Canadian Institute of Chartered Accountants in Toronto, of those earlier transitions. But the reality for Canada’s transition is that, in 2011, every transaction will be accounted for slightly differently.

“Nobody will really know until they actually go through and do the sums,” Salole advises. “[In the EU and Australia,] it depended on your industry. There were some industries that went up and others that went down. Will that apply the same way to Canada? I cannot say. Canadian GAAP was different from British GAAP, which was different from Australian GAAP, which was different from New Zealand GAAP.

“In executive compensation, what will stay the same? To the extent that executives are getting a straightforward salary, that is not going to change,” Salole explains. “To the extent that they might be getting bonuses on the values of shares, that again isn’t going to change because of moving to IFRS — it will depend on what happens in the market.”

However, he warns: “If executive compensation includes an incentive based on what the company has earned in a particular year, the use of IFRS may make the profit or loss that a company strikes in a particular year a little bit different than it would be under Canadian GAAP.”

Given trends in executive compensation, that may well be the case. Earnings per share and return on equity are key financial ratios that many firms have chosen to measure performance. All of the Big Six banks are on that bandwagon, adopting EPS and ROE as benchmarks a company needs to exceed in order to trigger bonuses for its leadership.

But both ROE and EPS will be affected by the transition to IFRS. For EPS, says Salole: “The denominator is going to be exactly the same [because the number of shares outstanding will not change]. But the numerator, which is your earnings number, will change because it is the result of all the new standards that you have applied.”

Ken Hugessen, founder of Hugessen Consulting Inc., a Toronto-based consultancy that works exclusively for boards of directors and compensation committees, is not worrying about the transition to IFRS. That’s because Hugessen sees the focus of a compensation model being on the long term — and the transition generally amounts to a one-year blip for the larger companies for whose boards he consults.

For smaller issuers, the transition will have a greater impact, Salole says, as it will give companies much more flexibility. Under IFRS, companies have the option of listing real estate for investment purposes on the balance sheet at market value instead of at book value, as is the case in Canadian GAAP. That could make for a leap in assets being carried in 2011. Further, IFRS leaves it to the discretion of the issuer to do the same for fixed investments — property, plant and equipment — as well.

@page_break@However, if a firm lists its PP&E at market value, there will be consequences: the higher valuation of these assets and the higher depreciation on the income statement could wreak havoc on expenses, and thus affect bonuses. IE